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How Overvalued is the Market, & Does it Matter?

The Shiller PE ratio is approaching 26… Near 2007 highs, and just below the Shiller PE ratio of 30 on Black Tuesday (start of the Great Depression).

The Shiller PE Ratio Explained

The Shiller PE ratio is the current price of the S&P500 divided by average inflation adjusted earnings over the last 10 years. The Shiller PE Ratio (also known as PE10) reduces the impact of recent earnings on the price to earnings ratio.

It is based on the teachings of Benjamin Graham who advised using 10 years of earnings data to smooth out earnings increases (and decreases) resulting from fluctuations in the business cycle. The Shiller PE ratio is named after Robert Shiller, the Sterling Professor of Economics at Yale who popularized the ratio in his book Irrational Exuberance. The Shiller PE ratio removes a great deal of business cycle “noise” from the valuation calculation. The chart below shows how overvalued the market is historically.

How Overvalued is The Market?

The mean Shiller PE ratio since 1881 is 16.53, and the median is 15.92. Based on these numbers, we can estimate that a ‘fair price’ for the market is a Shiller PE of around 16. With the Market at close to a Shiller PE of 26, the market is overvalued by about 60%. Now is not a historically good time to initiate a position in the S&P500. Of course, investors need not invest in the entire market. There are two important questions that dictate whether investing in any stock is a good idea with the market historically overvalued:

How long will the market be overvalued?

Are there individual stocks that aren’t overvalued?

How Long will the Market be Overvalued?

Short answer, I have no idea. The market has stayed at a Shiller PE of over 25 for much of the late 1990’s and 2000’s. Overvaluation does not imply an immediate correction. When you don’t invest in the market, you are incurring an opportunity cost; the cost of forgoing an investment. If the market is overvalued by 60%, grows at 10%, and doesn’t correct for 7 years, you are better off investing in the overvalued market than holding cash.

Seth Klarman of the $27 billion hedge fund Baupost Group was holding about 50% of his portfolio in cash at the end of 2013. He has gone on record stating that we are in an asset bubble. A 50% cash position is a very strong signal that Seth Klarman has a high conviction the market is overpriced and will soon correct.

In my opinion, it is unlikely the market will remain overvalued for another decade. Historically low interest rates are creating additional demand for risky assets. The stock market benefits greatly from low interest rates. If/when interest rates rise, stocks will become less attractive investments compared to bonds and short-term treasuries.

Are there Individual Stocks that are Fairly Valued?

There are very few stocks that are undervalued at this time. However, there are many stocks that are fairly valued, or slightly overvalued, rather than substantially over valued. Investing in fairly valued stocks will reward long-term shareholders through years of capital appreciation and dividend growth.

There are several great businesses that trade at fair prices at this time. Among them are Walmart, Exxon, and Pepsi (they are 3 of the top 10 stocks based on the 8 Rules of Dividend Investing). Walmart has a PE ratio of under 16, Exxon under 14, and Pepsi under 20. All 3 have solid 10 year growth rates, and all 3 have paid increasing dividends for over 25 consecutive years.